Then and now in mortgage hedging and rate volatility

Steven Abrahams and Brian Landy, CFA | October 18, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Traders in interest rate options at times have figuratively slept with one eye on the mortgage market, wary of risk spilling over into rates. That happens as mortgage managers hedge prepayment risk. Mortgage hedging at times has pushed up realized rate volatility by as much as 16% or more, and option prices with it. But today the impact of mortgage hedging on rate volatility is a shadow of its former self. Important parts of mortgage market structure have changed, and higher interest rates have largely eliminated refinancing. Rates would have to drop from today’s levels by an estimated 280 bp to 350 bp before we even got close to the impact that mortgage hedging had just a few years ago.

Little impact of mortgage hedging today

Based on an approach first outlined by Fed researchers Roberto Perli and Brian Sack, mortgage hedging today amplifies the fundamental volatility of interest rates by less than 5%. That means a fundamental shock that might move longer rates by 5 bp—a shift in Fed policy, a payroll or inflation surprise or similar—would produce a 5.25 bp response. A shock that might move rates by 50 bp would produce a 52.5 bp response.

The estimated impact of mortgage hedging on rates comes from analyzing the past impact of changes in mortgage convexity, mortgage duration and mortgage refinancing on 3-month options on 10-year swap rates. The analysis produces estimated multipliers—factors that multiply fundamental shocks—that differ depending on the separate measures used. So far in 2024, the multiplier of changes in convexity averages 1.00, implying no amplification of fundamental volatility (Figure 1). The multiplier of changes in refinancing averages 1.01, implying 1% amplification.  And the multiplier of changes in dollar duration averages 1.04, implying 4% amplification.

Figure 1: Amplification factors over time show today’s low impact of MBS hedging

Note: These estimates follow methods outlined in Perli and Sack (2003). The factors amplify the implied volatility in 3M10Y SOFR swaptions. The approach first filters the volatility by regressing it on 2Y10Y swaption volatility to extract expected long-term vol trends since hedging should only have temporary effects. The filtered vol is then regressed on lagged values of itself and each independent variable separately. Each variable represents the dollar convexity of the MBS market index, the dollar duration gap between MBS and the 10-year Treasury, and dollar amounts of refinancing based on the MBA refi index—all expressed in 10-year equivalents.
Source: Santander US Capital Markets

Much lower than past episodes of deep negative convexity and high refinancing

Amplification for each of these measures today is less than half as large as 2022 or 2021 when low interest rates raised the negative convexity of mortgages, pushed refinancing activity up and shortened mortgage duration significantly. Amplification is less than a third as large as estimated by Perli and Sack in early 2003.

Then and now in the history of mortgage hedging and rate volatility

The link between mortgage hedging and rate volatility first attracted wide attention in the early 2000s when two forces came together:

• The balance of outstanding MBS passed the balance of outstanding US Treasury debt by late 2000, making mortgage risk a growing force in US fixed income, and
• More MBS and related risk ended up in the hands of portfolios that actively managed interest rate risk, including Fannie Mae by 2003 with $902 billion of MBS, Freddie Mac by 2003 with $661 billion of MBS and large positions in the hands of the Federal Home Loan Bank System, mortgage servicers, mortgage originators and others

The portfolios hedging interest risk often did it dynamically, a strategy called delta-hedging. This involved trying to offset changes in mortgage duration by adjusting an interest rate hedge. A portfolio might buy MBS, for example, and then reduce the duration of the position by short-selling US Treasury debt. If interest rates then dropped, an increase in refinancing would shorten the duration of the MBS, forcing the portfolio to buy back Treasury debt to keep position duration on target. If interest rates rose, a drop in refinancing would lengthen the duration of the MBS, and the portfolio would have to sell more Treasury debt to keep position duration inbounds. Mortgage portfolios that bought Treasury debt as rates declined and sold as rate rose could amplify the rate move if their flows were large enough. Using Treasury futures or interest rate swaps instead of cash instruments produced the same result.

By 2003, storytelling about the impact of mortgage delta-hedging became so widespread that Perli and Sack decided to measure it. They found that as the MBS market became more negatively convex, or as MBS duration moved around, or as refinancing activity picked up, the interest rate volatility implied in options markets picked up significantly. They concluded, based on the market’s negative convexity, that in early 2003 mortgage hedging had amplified rate moves by at least 16%. “A fundamental shock that would normally cause a 50 bp movement on long-term rates,” they wrote, “would instead induce a 58 bp response.” Based on duration, mortgage hedging amplified risk by 22%, and, based on refinancing, by 28%.

Today, some important things have changed:

• Outstanding marketable Treasury debt, at $26 trillion, is now much larger than outstanding mortgage securities, at $9 trillion, and
• Fannie Mae and Freddie Mac have largely left the business of buying and hedging mortgage securities, Fannie Mae now with a portfolio f $84 billion and Freddie Mac with $88 billion. And although mortgage REITs play a bigger role today than they did in the early 2000s, they have not replaced the agencies

For the same level of negative convexity, for the same change in MBS duration or for the same magnitude of mortgage refinancing, the impact of mortgage delta-hedging on rates should be much lower today that it would have been in 2003.

Hedging could still have impact if rates drop significantly

Nevertheless, mortgage delta-hedging still has potential to push around rate volatility, although it would take a significant move in rates today. Most of the outstanding mortgage market trades at a deep discount to par, limiting exposure to volatile refinancing. To get back to the highest annual average amplification for each factor in either 2020 or 2021, mortgage rates would have to drop by 2.8% to drive negative convexity high enough, by 3.5% to shorten mortgage market duration enough and by 2.8% to push refinancing high enough (Exhibit 2).

Exhibit 2: Estimated rate moves to get back to recent peak MBS hedge impact

Note: Estimating the rate move needed to get back to peak amplification involved first determining the last time the corresponding metric was at peak level. The analysis then determined the percentage of then-outstanding MBS refinanceable at that time. Finally, the analysis determined the rate move needed today to make the same share of currently outstanding MBS refinanceable.
Source: Santander US Capital Markets

Sleep well, option trader

The historically low level of mortgage refinancing risk along with a much lower share of aggregate market risk in the hands of mortgage delta-hedgers should let option traders sleep well at night—at least the traders that remember earlier and more volatile mortgage markets. Of course, there are plenty of other things that have kept volatility high this year, so option traders may still have restless nights. But the ghosts of markets past are just that, ghosts. The reality is that mortgage delta-hedging is a small influence on rate volatility today.

* * *

The view in rates

Neutral on rates for now, given that the market is now priced roughly in line with the Fed dots through 2025, although longer rates are looking interesting. As of Friday, fed funds futures priced in another 45 bp of easing this year and 148 bp through 2025, implying fed funds at the end of next year around 3.33%. As fed funds head toward the neighborhood of 3%, the front end of the yield curve should drop to reflect the lower policy rate with the 10-year and longer end of the curve moving much more slowly. The 10-year rate at 4.07% looks a touch higher that it should be if fed funds approach 3%. Look for the 10-year to range around 3.75% by mid-2025, below implied 10-year forward rates by roughly 35 bp.

Other key market levels:

• Fed RRP balances closed Friday at $260 billion, down $72 billion in the last week. Since the Fed dropped policy rates by 50 bp on September 18 and set the RRP rate at 4.80%, balances initially jumped as T-bill yields dropped well below RRP yields. But in the last few weeks repo rates for general Treasury and MBS collateral have far exceed RRP, drawing balances away from the Fed facility.
• Setting on 3-month term SOFR closed Friday at 463 bp, up 5 bp on the week.
• Further out the curve, the 2-year note closed Friday at 3.94%, up 2 bp in the last week as Fed Chair Powell indicated a slow pace for easing and as payrolls and core CPI for September came in strong. The 10-year note closed at 4.07%, up 10 bp in the last week.
• The Treasury yield curve closed Friday afternoon with 2s10s at 13 bp, steeper by 9 bp in the last week. The 5s30s closed Friday at 51 bp, steeper by 6 bp over the same period
• Breakeven 10-year inflation traded Friday at 231 bp, up 8 bp in the last week. The 10-year real rate finished the week at 177 bp, up 4 bp over the last week.

The view in spreads

Strong September payrolls and core CPI has surprised the market and pushed implied rate volatility up again. Investors are questioning the pace of Fed easing. That is a marginal negative for spreads in risk assets. The Bloomberg US investment grade corporate bond index OAS nevertheless closed Friday at 79 bp, tighter by a strong 8 bp on the week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 143 bp, wider by 9 bp for the second week in a row. Par 30-year MBS TOAS closed Friday at 42 bp, wider by 8 bp over the last week.

The view in credit

Fundamentals for consumer and corporate credit still look relatively good. The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding so falling rates have limited immediate effect. Unemployment is showing signs of plateauing for now, and high levels of home equity and investment appreciation should buffer any stress on consumers. Leveraged and middle market balance sheets are vulnerable, although leveraged loan defaults and distressed exchanges have plateaued in recent months. Commercial office real estate looks weak along with its mortgage debt.